What Causes Inflation? Part 1

Apr 13, 2022 | Finconomics 101

While the Fed’s efforts to adjust interest rates and money supply to address inflation may be well intended, a better understanding of cause and effect is needed to solve the problem. 

What Causes Inflation?

The simple answer? Prices rise (inflation) when demand exceeds supply and prices fall (deflation) when supply exceeds demand. Let’s start with rising consumer demand. When the economy heats-up and Americans have more jobs and higher pay, their demand for goods increase. If this happens before the suppliers of the goods can increase their output capacity, then demand exceeds supply and prices go up (inflation) as the suppliers enjoy greater pricing power because of the increased demand. The suppliers don’t have to raise their prices, but they are human, and this would require a lot of self-control to resist. In any case, higher prices usually incent new suppliers to enter the market in pursuit of a profit and this trend helps to lower prices over time (depending on how long it takes to bring the new supply online).

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